The malaise that drove down the rupee

Desperate attempts to woo foreign capital by boosting investor sentiment is unlikely to result in a lasting solution to India’s currency travails

The recovery of the rupee and the euphoric rebound of the markets in the last few days would appear to suggest that the economy is back on track again. Nothing could be more wrong. The flurry of policy announcements in recent weeks is based on the diagnosis that the relentless slide of the rupee, attributed to the widening Current Account Deficit (CAD), can be arrested if and when capital inflows — as investments or borrowings — fill the gap.

Reserve Bank of India governor Raghuram Rajan’s recent announcement allowing banks to borrow from global capital markets at a time when interest rates are rising because of the expected reversal of the United States Federal Reserve’s easy money policy is tailored to this logic. Indian banks can now borrow up to 100 per cent of their combined net worth and long term borrowings from the international market (compared to 50 per cent earlier) and then “swap” them with the central bank. This is expected to augment the supply of foreign exchange by an estimated $30 billion, which is about one-tenth of Indian foreign exchange reserves. The markets reacted euphorically, but the risks of the country borrowing its way out of trouble have been much less appreciated.

The two-track policy — of making India more attractive to foreign investors by deepening “reforms” and of borrowing more — is fraught with serious consequences. The policy response suggests that the ongoing crisis is only a temporary blip in the Great Indian Growth Story. But it appears that the seeds of the crisis were sown in that very story.

The great credit binge

A striking feature of the story is that Indian corporates borrowed like there was no tomorrow — from not only Indian banks but also from overseas capital markets. Consider this: between 2003-04 and 2010-11 the Indian corporate sector’s share of net bank credit increased from 31 per cent of Gross Domestic Product (GDP) to over 37 per cent. In fact, since 2006-07, their share has been consistently higher than net bank credit to the government.

Infrastructure companies’ (power, roads and telecom) share in total bank credit increased from about 9 per cent in 2003 to more than 33 per cent in 2011. The spectacular increase is responsible for the mounting burden of non-performing assets in the Indian banking sector today. According to an oft-cited report in the media, prepared by the Credit Suisse Group in 2012, the debt of 10 Indian corporate groups whose interests range from oil and gas and steel to infrastructure increased from about Rs. one lakh crores in 2006-07 to Rs. 5.4 lakh crores in 2011-12 — a compounded annual rate of 40 per cent.

Asset bubble

The fact that private fixed investment did not increase at the same pace is perhaps because a large portion of the credit was diverted by Indian companies to what would appear to be an asset bubble — in land, shares in companies and other speculative assets. The clamour by corporate lobbies that interest rates be lowered has no respect for economic logic, given the state of the country’s external balances. They fail to appreciate that the era of cheap-credit fuelled growth is well and truly over.

But this increase in domestic credit was dwarfed by the remarkable increase in the inflows of foreign capital following the global economic meltdown in 2008.

The share of capital inflows — external borrowings, foreign direct investment (FDI) and foreign institutional investors (FII) — increased from about 5-6 per cent of GDP to about 9 per cent in 2011. The share of costlier short-term borrowings (almost entirely by private companies) in overall borrowings increased from 4.5 per cent in 2002-03 to 25 per cent in 2012-13. Companies, lulled into borrowing at illusorily low interest rates, have been surprised by sharp increase in the rupee-denominated value of their loans.

FDI illusion

Inflows of FDI registered a spectacular rise — from $9 billion in 2005-06 to $33 billion in 2010-11. Popular understanding is that while FII investments are volatile, FDI is much more stable, long term in nature and contributes to improving the competitiveness of recipient nations. However, the story of India’s dalliance with FDI is shockingly different and raises serious doubts about whether the ongoing attempts to woo investors is sustainable or even desirable.

A study co-authored by Biswajit Dhar, Director General, Research and Information Systems for Developing Countries, based on a painstaking dissection of every FDI project entailing an investment of $5 million and more between 2004 and 2009, provides shocking insights that prove that a large proportion of FDI is just as volatile and transitory as portfolio capital. The study that considered 2,748 projects, which accounted for almost 90 per cent of all FDI in the 2004-2009 period, found that the lowering of norms prescribing the minimum level of equity stake in an “FDI invested” project — from 40 per cent to 10 per cent — offered perverse incentives to capital flowing in the garb of FDI.

Less than half of the investment was actually FDI; private equity, venture capital and hedge funds, which are volatile and normally associated with short investment horizons, accounted for 27 per cent; and about 10 per cent was actually portfolio investment. Over 10 per cent of the “investment” was round tripping by Indian entities, which funnelled money back through tax havens in order to take advantage of tax concessions and other inducements available to FDI projects.

A large proportion of the investment was by entities masquerading as investors committed to the long haul or investments that enhanced the productive capacity. Indeed, manufacturing, which advocates of FDI said would be a key beneficiary, received only one-fifth of the investment; but even in this case portfolio and other short-horizon investors accounted for almost 40 per cent of the total investment. Interestingly, while much attention has been focussed on the rising import of oil and gold, little attention has been paid to the fact that the trade deficit in manufactured goods has widened from $1.5 billion in 2004-05 to $45.5 billion in 2011-12 (about 2.5 per cent of GDP).

If there is any truth in the old cliché that a crisis is also an opportunity, surely this is a time to rebalance the Indian economy on a more sustainable path that allows policymakers to use levers that are more easily within their control. Of course, this would require import curbs and other measures suited to these hard times. But rebalancing would also require the use of measures such as the fiscal deficit, which have been for far too long a strict no-no in the policymakers’ handbook.

The fiscal deficit obsession

The stubborn opposition to the good old-fashioned Keynesian logic of using a fiscal deficit to get the economy back on its feet is grounded in the apparently intuitive logic that equates a government deficit with a household deficit. A classic example of such misguided thinking is evident in the loud opposition to the Food Security Bill. Quite apart from the fact that such a measure would provide a measure of security to the poor, the implementation of the legislation promises economy-wide benefits.

First, the guarantee of subsidised food grains, which constitutes a significant proportion of the consumption basket for most people, will have the immediate effect of increasing their disposable income. This is not trivial, given that the growth of consumption expenditure has halved between 2009 and 2012.

Second, the provision can play the role of an economic stabiliser because food prices determine the floor wage level, which is why they are termed a wage good. The guarantee would thus not only help in controlling food prices but also stabilise wages. Indeed, it is perplexing that industry lobbies are attacking the provision of an enhanced social wage, from which they stand to benefit significantly.

Third, if the fiscal deficit is run in an imaginative way, even more can be achieved. For instance, coupling the food guarantee to the MGNREGA can help in the construction of a countrywide network of godowns for the Food Corporation of India.

Of course, a cash transfer scheme would negate much of the potential economy-wide benefits that would accrue from the implementation of the food security legislation.

Building storage godowns or tall grain silos for food grains in Punjab and Andhra Pradesh is a dire necessity. Even more dynamic will be a proposal made by me to build small size silows with cold rolled GI Sheeting to be located in villages where people could store their produce until a better price appears. This suggestion was made to the CSIR in 1970 and was rejected. I did work on this in McMaster University in CAnada which helped with a CIDA(Canadian International Development Agency) post doctoral summer fellowship for three summers.

from:
subbanarasu Divakaran

Posted on: Sep 18, 2013 at 02:15 IST

c) What happened in the 7 years NDA rule ? Was there any reversal of Policies initiated by MMS / PVN ? If so, what are they ? If not, can we not attribute the reversal, if at all any, to Yaswant Sinha / Jaswant Singh ?
d) If a net shortage of just about 100 Bn USD per year ( 480-300-80) in an open economic system ( exports increases, import decreases as per demand supply gap for Dollors)can collapse an economy of USD 1800 Bn, then no country in the world can survive ! How many of the readers have seen the FE conversion trends of various currencies in the past 10 years ?
e) Which of the Editorials / Experts have supported the Petrol / Diesel price hikes in the past few years ?
f)Which of the Experts / Papers who write big articles on rupee depreciation today wrote anything about the possibility of USD touching 68.80 about 4 months back ?
g) Now, let Sridher predict USD for the next 6 months and publish an article. It will be very useful, rather than writing such a confusing article !

from:
K.Periasamy

Posted on: Sep 18, 2013 at 01:36 IST

I have to agree with the previous readers' comments. The reference to Keynes was peculiar, and the author's opposition to cash-transfers is far from explained. But the critique of the new RBI Governor's policy is very astute.

from:
prakash

Posted on: Sep 17, 2013 at 23:49 IST

An excellent article that lays the plot bare for everyone to grasp. Author seems to be surprised that "that industry lobbies are attacking the provision of an enhanced social wage, from which they stand to benefit significantly". There is no need to be surprised by such a motive shown by private corporates of India. They do not see the long term benefit that ensuring food security will benefit a healthy new generation in India. Instead they look at the short term disadvantage that this will cause a rise in wages of the labour class and hence a dip in the Corporate profits.

from:
Janarddan

Posted on: Sep 17, 2013 at 22:30 IST

Every one here seems to be focusing the loss in Rupee as a loss of the Indian Nation. Look at China, despite a strong Renminbi, in true sense, their people and government is very satisfied of a week currency.

It helps China become the world's go to source for manufactured products, and keeps a much larger workforce employed.

We could let the Rupee fall to RS 100 per USD and see manufacturing - no just assembly of pre-manufactured components, rise, and along with that employment and exports rise. Increase in exports will naturally offset our trade balance deficit.

from:
Jay

Posted on: Sep 17, 2013 at 22:06 IST

Well written article. But more clarity is required in last 2-3 paragraphs.it seems author is favouring high fiscal deficit despite so much hue and cry over it, it has already reached at alarming high level and has played very significant role in bringing down economic growth rate. Undoubtedly, food security bill was much needed but timing is very wrong and the decision to bring it at such time is politically influenced.

from:
Abhishek

Posted on: Sep 17, 2013 at 21:34 IST

When import of oil eats away the foreign exchange,it obvious how we use energy less.Public transport should be the priority as happened in Gujarat.Their system of "ST" and "Local TransportAMTS" should be copied in all states.
Also the life style of people for transport should be controlled.Encourage train travel more than road.Make train and goods train cheaper even with some loss.

from:
Ashok

Posted on: Sep 17, 2013 at 19:03 IST

A very strange yet a finely crafted sensible article by Mr. Sridhar. However, to my surprise the last paragraph was a complete clutter and mostly deviating from the title. With a staggering 70% of oil imports into India, these FDI and FII make a passing cloud phenomenon in the above said segments and does not help in the dire situations. A simple panacea "A very strong No to oil imports rely on Conventional energy" for the above said malaise. Even the author knew this simple logic, instead went on to Keynesian logic so as to confuse the reader. The magic wand to refine and reform our crippled economy lie in the hands of our policy makers not the RBI governor. They should elveate the Green energy usage in the country like Adhaar and FSA-
2013. Even the next Five year plan should focus on Alternative energies, and tame the investors to R&D in this field and prevent from buying and relying on foreign technology and start importing our own clean energy tech to the entire world.

from:
sandeep kumar

Posted on: Sep 17, 2013 at 16:39 IST

It is abundantly clear from the article that foreign exchange credits brought into India in the guise of FDI by a few unscrupulous Indian corporates were misused by them by converting the FOREX into rupee for investments in unproductive segments like real estate. Would there be any punishment for those corporates?

from:
N.Chellappa

Posted on: Sep 17, 2013 at 15:06 IST

The question to the author is:
1) On Food Security bill, your argument that it will revitalize economy is similar to situation in Japan, where money was spent on bridges that went no-where to revive the economy. Expectedly, this didn't help revive the economy and only led to further detrioration in the fiscal health of the economy.In the current markets scenario, taking such measures against the investor sentiments creates further depreciation pressure on ruppees, higher inflation and an even higher fiscal deficit
2)Cash transfer is better to stop the leakage, and will guarantee that intended recepients receives the money and this will also increase the disposable income - just like the Food security bill
3)MNREGA and Food Security bill - Interesting idea, but think a lot of study and research is needed on its effectiveness and synergy

from:
saurabh

Posted on: Sep 17, 2013 at 12:42 IST

Efforts to prop up rupee by window dressing wont work for long..Export has to increase and unwanted imports to be reduced..country to explore ways of reducing import of crude by seriously looking into alternate energy sources..

from:
ramesh

Posted on: Sep 17, 2013 at 10:34 IST

Well written article ! Though, with the last para, can't totally agree with it.
How FSB is going to get economy wide benefits,please elaborate further.
"Of course, a cash transfer scheme would negate much of the potential economy-wide benefits that would accrue from the implementation of the food security legislation. "
What a way to end the article !
Just made the statement but it seems to be exact the opposite.
Through out the article , Mr. Sridhar is right on the track to a perfect diagnosis, but he erred on the last line.